3/04/2002 @ 12:00AM

Someone Knew

The Enron belly flop stunned almost everyone, but a select circle of Wall Street pros had an early warning system you can’t access.

Tyco, the Gap, Ford Motor Credit and Dow Chemical: Are these the next corporate implosions waiting to happen? Maybe not, but a little-known early warning system indicates they are entering dangerous territory.

The warning system is an obscure electronic-trading market where banks and other big players buy and sell credit-protection contracts as an insurance policy against loans that might go bad. Lately the price of such contracts is surging, for these companies and others.

It’s arcane stuff most investors could ignore, but for this:This credit-protection market sounded alarms about Enron months before the scandal-scarred energy giant collapsed. Enron’s stock didn’t begin its most breathtaking plunge until mid-October, when the company’s offshore partnerships were uncovered. But two months before that the trouble signs showed up in credit trading.

On Aug. 15, the day after Enron chief Jeffrey Skilling abruptly resigned, Enron stock barely budged, closing just above the $40 mark. But on the same day, the price of an Enron credit contract jumped 18%. Contracts bought that day were priced at 185 basis points ($185,000 annually for protection against default on a $10 million loan). And by Oct. 25, as the troubles sparked headlines, Enron stock had dropped more than 50%, while the credit contract had soared in price to $900,000 per $10 million annually.

Even at the much higher price, it was a great deal. Just as Citigroup used the credit-protection approach to insure $1.4 billion in loans to Enron, other banks and security firms shrewdly sidestepped a big hit by purchasing credit-protection contracts on Enron.

“It’s like taking out extra fire insurance just as your house starts smoking,” says
Sunil Hirani
, cofounder of
Creditex
, an intermediary in this relatively new game. “What’s the biggest risk in the financial system? Credit risk. Everyone has it. And it’s the least-managed risk in the system.”

Too bad credit-derivatives prices aren’t published in the paper like stock prices. You could have seen trouble brewing at Gap well in advance of credit-rating downgrades(see chart, below).

But for now the quotes are known only to a small circle of professionals trading credit insurance in a wholesale-only market. The trades typically cover $10 million tranches of five-year bank debt.

The buyer doesn’t have to be someone hedging a loan. It could be a speculator betting on financial trouble. Buying credit coverage is roughly equivalent to selling the debtor’s bonds short while going long a comparable U.S. Treasury note.

If the debtor’s balance sheet goes from bad to worse, the buyer of the credit derivative will make a profit. If the debtor strengthens, the buyer loses money on the derivative.

Either way, there’s money in this for the marketmakers. It’s estimated that middlemen peeled off $1 billion in profits a year on upwards of $1.5 trillion in credit protection trading last year. That volume is up from $50 billion in 1996.

How much profit or loss is there on a given swing in the derivatives pricing? It’s a complicated formula akin to the one relating yield swings to bond prices. On a five-year bank loan a swing of 100 basis points in the credit insurance translates into a gain or loss of not quite 5% times the debt being covered.

Deutsche Bank, J.P. Morgan and other international banks started the credit trading market six years ago. You can hedge away risks from currencies, energy costs, even the weather–why not credit quality? The Russian default and the Asian crisis of 1998 triggered immense desire by banks to hedge their exposure to calamitous events.

In the wake of Enron, Kmart’s Chapter 11 filing and the shocking accounting problems at Global Crossing, Tyco and others, there is an explosion of interest in the market for insuring against credit defaults.

And nowadays even prime credits are getting harsh judgments in the derivatives market. General Electric Capital Corp. gets a triple-A credit rating from the credit-rating agencies, but even so, the cost of insuring GE’s credit has tripled since early February.

Now an insurance policy against default by the GE subsidiary over five years will cost you 34 basis points (34-hundredths of a percentage point) of your yield. “The market thinks its credit rating should be a low Aa rather than Aaa,” says Sanjeev Gupta, head of credit derivatives at Credit Suisse First Boston. Other companies witnessing embarrassing rises in derivatives prices are Household Finance Corp., farm-equipment maker Deere & Co. and Countrywide Credit, a home mortgage lender.

Tyco’s accounting looks a little iffy and investors are worried it won’t repay its debt. You can see that fear writ numerically in the derivatives market. Protection against default on its 6.375% ten-year bonds has soared to 425 basis points. Correspondingly, the bond’s price has fallen, from 98 cents on the dollar in late January to a recent 82 cents.

Gap’s clothing isn’t as chic as it used to be, and you can see that in the derivatives price. Credit insurance for Gap bank debt spiked from 82 basis points in late August to 535 recently. The stock is in trouble, too, but hasn’t seen the same degree of movement. Since August shares have fallen from $21 to $13.

The credit-derivatives market sends warning signals that credit ratings are under pressure to fall from investment grade to noninvestment grade, says Glenn Reynolds, founder of CreditSights, a private credit-research firm.

Reynolds notes that Nortel Networks, WorldCom and Halliburton are getting investment-grade credit ratings (BBB and better) by Moody’s and Standard & Poor’s, but are getting panned in the derivatives market, where insurance coverage indicates junk status for the debt.

At times the market for credit protection can be wrong. The upshot: tremendous volatility in the pricing of credit protection. When retailer J.C. Penney had trouble with suppliers last year, the premium required to protect loan exposures rose to 750 basis points. But Penney was not headed for default and the premium sank back to a recent 450.

Someone who bought Penney coverage at the 750-point price is a loser. If he hangs onto the credit insurance policy until the loan’s maturity, he has to cough up 7.5% of the principal amount every year to the seller of the policy. (Should Penney indeed stiff its borrowers, the seller of the policy would owe 100% of the principal, less the market value of the loan after default.)

If the buyer at 750 points wants out early, when investors are feeling better about Penney’s prospects, he will have to pay to get someone to take the derivative contract off his hands.